A3Q5

We have two independent and mutually exclusive projects, A and B. Project A requires an initial investment of $1000, and will yield $500 of cash inflows for the next three years. Project B requires an initial investment of $3,500, and will yield $1,000 of cash inflows for the next five years. The required return on both projects is 10%.

a. What are the net present values of Project A and Project B?

b. What is the problem with using the NPV investment criterion in this case? What alternative criterion should be used?

c. Which project should be chosen?

The cash flows and required return given are all in nominal terms. Given that the inflation rate is 3%, answer the following questions:

d. What is the real rate of return based on the exact Fisher equation?

e. What are the real cash flows from Project A and Project B?

f. What are the real net present values of Project A and Project B? (Hint: The real NPV should be the same as the nominal NPV.)

g. Which project should be chosen based on the real cash flows and real rate of return?